The Central Banker
Why this chapter
To understand who controls the amount of money in a country and how, and why the printing press in the everyday sense is a myth.
An analogy
Picture a building with two floors. On the first live people and companies: they pay each other with what sits in their accounts. On the second live only banks, and they have their own separate currency that they settle with among themselves. There is no elevator between the floors: what happens upstairs does not reach downstairs directly. The eighth chapter is about the owner of the second floor. It can create second-floor money with a stroke of a pen, but it cannot put that money directly into your account. And almost every argument about inflation and the printing press is an argument between people who have not noticed that there are two floors.
How it works
The central bank has its own balance sheet and its own money — reserves, which only banks can own. This is “money for banks”: the public cannot hold it. M2 (cash + the deposits of people and firms) and reserves are separate circuits!
QE with a bank: the central bank buys a bond from a bank → the bank's asset changed (bond→reserves), M2 did not grow. QE with a pension fund: the money passes through a bank → the fund now has a deposit → M2 grew. One operation, a different effect depending on whom you bought from.
Rescues: a bail-out puts taxpayers' money in; a bail-in turns the debts and deposits of creditors into equity (Cyprus, 2013). ELA is lender-of-last-resort credit against collateral: it cures a panic, it does not cure a hole in capital.
The words of this chapter
Reserves
Banks' money in accounts at the central bank. This is a separate kind of money: people and companies cannot hold it, and banks pay each other with it.
They are needed because banks are not satisfied with each other's entries: they need a shared asset — an obligation of the central bank, equally good for everyone.
The policy rate
The interest the central bank pays banks on money that sits with it doing nothing. This is not the price of printing but income for inactivity.
It was invented as a lever: by raising the rate, the central bank makes idleness profitable, and lending contracts by itself.
QE
Mass buying of bonds by a central bank. It pays for them with money it creates at the moment of purchase.
It was invented to bring down the yields on long securities when the ordinary rate has already been lowered to its limit.
ELA
An emergency loan from the central bank to a bank, against collateral and at a raised rate.
It was invented back in the nineteenth century on a formula: in a panic, lend freely, against good collateral, at a penalty price. The generosity puts out the panic, the penalty scares off those hoping to profit, and the collateral protects the lender.
Bail-in
The rescue of a bank at the expense of its own lenders: their claims, large account balances included, are turned into a stake in that bank.
It was invented after rescuing banks at taxpayers' expense became politically impossible.
An intervention
The sale of foreign currency by a central bank to support the rate of its own. The domestic money it receives in exchange it destroys.
It was invented as a way to smooth sharp moves in the exchange rate, not as a way to set it.
P&A
A way of burying a bank over a weekend: a healthy institution takes the customers and the good property, and the bad stays in the shell to be wound up.
It was invented because the main enemy is panic, not the death of an individual bank.
What happens to the balance sheet
Take the same operation apart with two different sellers. The central bank buys a bond. If the seller is a bank, only the composition of its property changes: it had more securities, now it has more money in its account at the central bank. Not one customer balance changed. If the seller is a pension fund, the money arrives in the fund's account at an ordinary bank: the fund's balance grew, and the bank's money at the central bank and its obligations to a customer both grew. In the second case people and companies have more money; in the first they do not. One operation, two different outcomes, and the only difference is who the seller was.
Where the money comes from here
A central bank does not earn in the ordinary sense, although it does have income: it pays less on its obligations than it receives on its property. Banks earn interest on the money they keep with it at no risk, and that sets the floor under the return of their whole business. The ones who lose in this chapter are those whose claims turned out to be more junior than they thought: the holders of large uninsured balances at a bank being rescued. Here is why this matters to you: keeping money in a bank makes you an unsecured lender, and your place in the queue is set by law rather than by your feelings. That is exactly why deposit insurance exists, and exactly why it has a limit.
What people usually get wrong
The common belief. The central bank prints money, and that is why prices rise.
What is actually true. Cash gets into circulation only by exchange: a bank swaps money in its account for banknotes, and you swap a balance for notes. The amount of money does not change at all.
The common belief. Mass buying of bonds by central banks inevitably causes inflation.
What is actually true. When they buy from banks, only second-floor money grows, and it never reaches people. That is exactly why years of that policy after 2009 passed without a burst of prices.
The common belief. The central bank will save any bank, because it can create as much money as it likes.
What is actually true. It can close a shortage of money, but not a hole in the owners' cushion. A secured loan does not make an insolvent bank solvent.
After this chapter you will be able to
- explain why issuing banknotes does not increase the money supply
- separate a liquidity crisis from a capital crisis before the first line is extended
- tell the reserve circuit from the deposit circuit and not mistake growth in one for growth in the money supply
- work out from the question “who did they buy from” whether a central bank operation will grow the money supply
- treat a deposit as an unsecured loan to a bank and know your place in the queue
Check yourself
The central bank printed a large amount of banknotes and gave them to banks. Do people have more money?
No.
The bank paid for the banknotes with money from its account at the central bank. This is an exchange of one form of an obligation for another. The operation never reaches people at all.
The central bank bought bonds from an insurance company. Did the money supply grow?
Yes.
An insurance company is not a bank, so the money arrived in its account at an ordinary bank. Its balance grew, which means first-floor money grew. Had they bought from a bank, it would not have.
A bank has no money for its payments, but the owners' cushion is intact. How will the central bank help it?
With a secured loan.
This is a classic shortage of money, and it is treated quickly and reliably. But if the hole were sitting in the owners' cushion, no loan would help: it would only postpone the end and make it more expensive.
In short
Banks have their own separate currency for settling with each other, and people do not use it. The central bank can create that currency with a stroke of a pen, but it cannot put money directly into your account. That is why buying bonds from banks does not raise prices, while handing money out directly to people does. Cash creates nothing at all: it is simply another form of the same money. If a bank is sinking, the central bank can lend to it, but it cannot give it back what it has lost.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.